Why Emerging Markets Have Become an Unlikely Haven From Global Risk

  • Doom-and-gloom talk contradicts bond, stock, currency gains
  • Fed, commodities and Trump seen as obstacles to EM rally

JPMorgan's Titherington Says EM in a Pretty Good Place

If the U.S. Treasury market’s 2013 Taper Tantrum revealed the fragility of emerging markets, political turmoil this year is highlighting their resilience.

UBS AG, Goldman Sachs Group Inc. and a host of other naysayers have cautioned against excessive optimism as investors have piled into stocks, bonds and currencies in developing nations. They say traders are ignoring the risks of political turmoil, trade protectionism and subdued prices for the commodity exports the countries depend on.

But for all the talk of doom and gloom, the rally continues unabated. Equities and currencies in the developing world are heading for the best annual start in 11 years and their dollar-denominated bonds have jumped to a record. The appetite for higher-yielding assets has increased rather than diminished with the end of ultra-low borrowing costs and the rise of populism, and there are some very good reasons why.

Here we take a look at the common arguments against emerging markets, and provide the bullish counterpoint.

1) Political Risks From Venezuela to Turkey to North Korea

THE CONCERN:
Investors will dump emerging-market assets because of political instability, including the riots stemming from food shortages in Venezuela, the turn toward more autocratic rule in Turkey and a bellicose North Korean regime. That’s not to mention trade losses arising from Donald Trump’s protectionist crackdown and the U.K.’s bid to leave the European Union.

THE REALITY:
All those things are worrisome, but some of the biggest gains this year are coming from countries going through political upheavals that investors bet will be net positives in the long term. South Korea’s Kospi Index has risen to a six-year high after its first female president was ousted, Istanbul stocks are giving the second-highest return in emerging Europe after Turks voted to abolish their parliament, and South Africa’s rand is heading for the continent’s best performance amid a row surrounding President Jacob Zuma. At the same time, developed nations are looking unstable themselves these days, with a hard-to-predict U.S. president, the ascendance of an anti-globalization party in France and the U.K.’s Brexit negotiations.

“Geopolitical risk is not just an emerging-market phenomenon at the moment,” said Simon Quijano-Evans, a strategist at Legal & General Investments Management Ltd. in London.

WHAT’S NEXT:
Investors seem most concerned about specific countries that have the most to lose from global tensions. The widespread optimism about Russian stocks that followed Trump’s election has all but evaporated as expectations for a quick easing of U.S. sanctions fade.

2) Valuations Are Getting Too Rich

THE CONCERN:
Emerging-market assets are becoming more expensive, and that may push investors to sell.

THE REALITY:
The valuation discount on emerging-market stocks relative to developed markets is actually about 10 percentage points wider than its 10-year average. In fact, the shares have gotten cheaper by some measures since the rally began in January 2016 as increases to earnings forecasts outpaced gains in the stock market.

The premium investors demand to own developing-nation sovereign bonds rather than U.S. Treasuries has narrowed about 200 basis points in the past 14 months, but still has about 70 basis points to go before reaching 2010 levels.

WHAT’S NEXT:
Of the 142 companies on the MSCI Emerging Markets Index that have reported first-quarter earnings, more than half beat the median sales and profit estimates of analysts. That signals strategists haven’t gotten ahead of themselves in forecasting higher profits.

“Generally emerging markets have come from a pretty low base so they have got further to run,” John Roe, the London-based head of multi-asset funds at Legal & General Investment Management, said in an interview on Bloomberg TV on Tuesday.

3) Lackluster Commodities Prices Are an Ominous Sign

THE CONCERN:
Because so many developing nations have a big portion of their economies tied to commodity production, the flat-lining in materials prices over the past year and the recent selloff in oil bode ill for growth.

THE REALITY:
Emerging-market assets are breaking their link with commodities as traders focus on the rich rewards offered by carry trade -- where investors borrow in low-interest-rate countries and buy higher-yielding assets. High interest rates from Russia to Brazil have offered an attractive proposition to investors, allowing currencies from the energy exporters to shrug off this year’s dip in oil prices.

WHAT’S NEXT:
Developed economies don’t seem to be in a rush to quickly raise interest rates from historic lows anytime soon. Still, it’s possible the divergence from commodities can run only so far. The law of averages may kick in, limiting those gains.

Read: Emerging-market currencies may be set for an imminent pullback

4) The Surge of Inflows to Developing Nations Isn’t Sustainable

THE CONCERN:
As the Federal Reserve raises interest rates, emerging markets will see capital outflows.

THE REALITY:
Emerging-market funds have attracted net inflows for three months straight this year as U.S. President Donald Trump’s fiscal stimulus measures were put on hold and the Fed signaled it will raise rates gradually. That suggests that investors are well aware of the outlook for U.S. borrowing costs, but are finding other reasons to be bullish on emerging markets.

WHAT’S NEXT:
It’s possible that interest rates in developed markets reach a level that causes investors to reconsider their love for emerging markets, but it hasn’t happened yet. David Woo, the head of global rates and FX strategy at Bank of America says that while more money can certainly flow in, investors should be cautious.

“At this point you want to sit as close as possible to the back of the cinema because if there’s any scare or panic, people are going to be running for the door,” Woo said in an interview on Bloomberg TV on April 25.

5) Trump Is Bearish for Emerging Markets

THE CONCERN:
The so-called “Trump Trade” -- betting on faster inflation and higher corporate profits -- has made emerging markets unattractive relative to U.S. assets

All you wanted to know about this thing called “Trump Trade”

THE REALITY:
Investors have scaled back their initial optimism over Trump’s spending plans and tax cuts as the president stumbles in his initial efforts to push through9 his policies. As the outlook changes, short traders have cut more than a $1 billion of bearish bets against a bond ETF focusing on developing countries.

WHAT’S NEXT:
Treasury Secretary Steven Mnuchin said Wednesday that the Trump administration will propose a corporate tax rate reduction to 15 percent and lawmakers are broadly in agreement over tax reform. The proposal could be a boon to corporate profit and reignite the idea that the U.S. is the better destination for investment. But we’ve seen other announcements of this kind ultimately lead to disappointment.

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